Technical Analysis - What is it and How to Use It

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Buying or selling a currency pair is a decision that should come at the end of a logical process. There are various reasons why people buy or sell a currency: some are doing that to protect against inflation, some to protect against other risks, some to simply diversify their portfolio and savings, etc.

No matter the reason behind it, the process is called an analysis. If you are buying gold to protect against inflation, you're trading based on fundamental analysis.

When you’re depositing your money in Switzerland in a Swiss Francs deposit, this is the result of fundamental analysis as well. You look for safety against something.

But buying or selling a currency/currency pair, or speculating on it, can be done using technical analysis as well. All retail traders are falling into this category: they are technical analysis traders.

Technical Analysis

A proper definition for technical analysis would be the interpretation of future moves based on previous data. If history tells us much about future, why not this to be true in trading as well?

Technical analysis always involves a chart. A chart is the technical picture of the moves a financial instrument makes.

No matter the underlying product, if it moves, it leaves a trace or a chart. There are various chart types: bar, candlesticks, market profile, renko, heiken ashi, point and figure, and so on. They all are part of the technical analysis and a technical reason is behind their interpretation.

Indicators

Indicators are the main part of technical analysis. There is no trader in this world that didn’t use, at one moment, an indicator.

Trend indicators are applied on the actual chart. They show the underlying trend and traders using them are riding a trend.

In a bullish trend, dips are being bought, while spikes are being sold in a bearish one. Moving averages, Bollinger bands, SAR... all these are examples of trend indicators.

Trend indicators are working great in trending markets. The problem is that trends are not that common, especially on the Forex market.

It is a well-known fact that markets spend most of the time in consolidation or ranges. As an estimate, over sixty-five percent of the time, the market is ranging.

Think of it for a minute: how many “lively” Asian sessions did you see lately? The answer is almost none.
In a range trend indicators cannot help. In this situation, oscillators are great trading tools.

Oscillators are applied at the bottom of a chart and are calculated based on a mathematical formula. The main idea behind trading with an oscillator is to use it as a benchmark for the underlying current price.
It means that the current price and the oscillator should move in a coordinated fashion. If price, say, makes two higher highs, the oscillator should do the same. If price fails to make the second higher high, the oscillator should mirror the move.

Sometimes, though, one of them is showing a different path. This is when price and oscillator are diverging.
As a rule of thumb, between the current price and an oscillator, a trader’s decision should stay with the oscillator. Why is that?

The right answer is because the oscillator considers multiple previous data before plotting the actual one. For example, the most popular oscillator of them all, the RSI (Relative Strength Index), comes with the default setting of 14.

It means that the oscillator considers 14 periods, or candles (in a candlesticks chart) before plotting the current value. This should be a more valuable information for the trader than the current price.

Oscillators are great tools to use when the price is diverging, and divergences are acting as confirmation for a trend reversal. A bullish divergence is a great buying signal, while a bearish one is a selling signal.

However, as always, there’s a catch here too! Price can stay in a divergence mode longer than the trader can stay solvent.

Fortunately, technical analysis is not only made by trend indicators and oscillators. Entire trading theories have developed in time and still are developing to these days.

Trading Theories

A trading theory is a concept that is applied on a chart and it is backed by a logical process. If this happened, that should follow, if that follows, the next step is this... and so on.

Trading theories are backed by historical data, and historical data is based on patterns. Like in life, things are repeating in trading too. Patterns that formed a long time ago on a monthly and yearly chart, are forming daily on the five-minute time frame.

Only because the timeframe is different, it doesn’t mean the patterns are not the same. This is what trading theories are being based on.

Elliott Wave Theory

The Elliott Waves theory is the most popular trading theory. It is based on forecasting future prices depending on the patterns that formed in the past.

While it is looking like a simple approach to complex markets, it is one of the most powerful predicting tools if used appropriately. Unfortunately, few traders master it.

Gann Theory

The Gann theory is based on the strong belief of W.H. Gann that every financial product is moving in its own way. The angle is called the 1x1 angle and it is the base of a complex trading theory that incorporates astrology and mathematic principles.

VSA

VSA stands for Volume Spread Analysis and it is a popular approach to trading. The idea is to find imbalances between supply and demand and trade them.

Unfortunately, the volume showed by any Forex broker is not the entire volume of the Forex market, but only the one of that broker. While it is giving an estimate, it cannot be interpreted using the VSA approach.

Conclusion

This article is merely showing what is part of technical analysis, but the subject is so vast that it will need much more space to cover. What is important is to understand that prices can be forecasted, and there is no holy grail to trading.

The technical and fundamental analysis should be used together as part of a trading decision. At the end of this due-diligence process, a trade can be taken.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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